Here’s How Credit Card Interest Works

Credit cards are great — you can earn cash back, gift cards, or even free travel. But using a credit card can come with a price: You’ll pay interest on any amount you don’t pay back on time.

Ideally, you’ll be able to pay the card off each month and not worry about any interest charges. But sometimes emergencies happen, and you may occasionally have to carry a balance and pay interest.

But how does credit card interest work, exactly? It’s not as straightforward as it may seem. To understand how much you’ll be charged, you need to understand how your credit card’s interest is calculated, plus your average daily balance.

Read on to find out how interest on credit cards works, including when you’ll be charged and how to calculate how much you could owe.

How does credit card interest work?

In a nutshell, interest is a fee for borrowing money — a percentage of the amount you spent on your credit card. When you look at a credit card’s fine print, you’ll see something called the annual percentage rate, or APR. This is the interest rate you’ll pay for that specific card, plus other charges and fees.

A credit card’s APR can be fixed or, more commonly, variable. A fixed APR remains the same and doesn’t change. A variable APR can fluctuate up or down, depending on a variety of factors.

A credit card can even have more than one APR, so check the fine print to see what rates you could be charged. You might see the following:

• Purchase APR: Think of this as your “regular” APR, which is the rate you’ll be charged for purchases you make with your credit card. This could be a single APR that applies to all cardholders, but often there’s a range of possible APRs, in which case your specific APR will depend on your creditworthiness.
• Introductory APR: Some credit cards will offer a lower interest rate as a promotion to entice you to sign up. You could pay low or no interest for a predetermined amount of time. Depending on the issuer, this can apply to balance transfers, purchases, or both.
• Cash advance APR: The rate you’ll pay if you borrow cash from your credit card — it could be much higher than a purchase APR and may not offer a grace period.
• Balance transfer APR: When you transfer a balance from a credit card to another, you could be charged a balance transfer APR.
• Penalty APR: When your credit card payment is late, this APR could kick in. It’s typically higher than other APRs.

When are you charged credit card interest?

Credit card issuers typically provide what’s known as a grace period — a specified amount of time between the end of your billing cycle and when your credit card payment is due — in which you’re not charged interest. If you pay the entirety of your balance during the grace period, then you do not pay any interest.

However, if you carry a balance, the purchase APR will be applied to the unpaid amount. Exceptions include introductory APRs, where you’re not charged interest for a specified amount of time for purchases or balance transfers.

In most cases, you won’t receive a grace period for cash advances — you could be charged interest right when you take out cash.

How is credit card interest calculated?

Most issuers calculate credit card interest daily, based on your average daily account balance. In other words, interest accrues daily, and the longer it takes you to pay off the balance, the more interest you’ll pay.

Here’s how to estimate how much interest you could pay on your credit card balance:

• Calculate your daily periodic rate: Take the purchase APR and divide it by 365 (some issuers divide it by 360, so check the fine print).
• Determine your average daily balance: To find this number, look at your transaction history from the last billing cycle. Add up your balances for each day, then divide that number by the days in your billing period.
• Calculate interest charged for billing cycle: Take your daily periodic rate and multiply it by your average daily balance. Then take that number and multiply by the number of days in your billing cycle.

Here’s an example to show you this calculation in action. Your APR for a credit card is 14.99%, which means your daily periodic rate is:

Your average daily balance is $3,000. Multiply your daily periodic rate (0.00041) by your average daily balance ($3,000) and the number of days in the billing cycle (30).

In other words, you’re being charged $36.90 each month to borrow $3,000 from your credit card issuer.

If you must carry a balance on your credit card, there are ways you could lower your interest charges by paying it off more than once. This could lower your average daily balance and, therefore, your interest payments.

Let’s take the above example. If you have $1,500 to pay down your $3,000 balance, your average daily balance will be $2,200 if you make your payment in one lump sum on the 15th day of your billing cycle. However, if you paid $750 on day seven and another $750 on the 15th, then your average daily balance will go down to $2,000.

To take it one step further, this means that if you paid $1,500 on the 15th, you’ll pay $27.06 in interest for that month, whereas making two payments means you’ll pay $24.60 in interest.

Better yet, try to pay your entire balance off each month so you’re not being charged interest at all, including residual interest. 

How do issuers determine your APR?

Many credit card issuers base interest rates on an index known as the Prime Rate. To find your APR, the issuer will take the Prime Rate and add a margin based on your creditworthiness.

Say the Prime Rate is 5.50%. If you have excellent credit, the credit card issuer might add 12% to the Prime Rate, giving you a 17.50% interest rate. But if you have average credit, the issuer would add more — say, 18% — to the Prime Rate, giving you a 23.50% interest rate.

To put it another way, the lower your credit score, the higher your rate could be. That’s because you’re perceived as more of a risk to the issuer.

Bottom line

When shopping around for credit cards, understand what APR the issuer is offering so you have an idea of what you’ll pay in interest in case you do carry a balance.

If you find the APR on a credit card is too high, you can either strive to pay off the balance each month or look for a card with a lower interest rate. This could mean working on improving your credit score and getting preapproved for an offer to compare cards before taking the plunge. And for more information, learn how to avoid interest on credit cards altogether. 

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